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Tuesday, August 12, 2008

Security Analysis: Chapters 44 and 45

Security Analysisby Ben Graham and David Dodd is a must read for anyone serious about value investing.

The authors delve further into the discussion of why companies trade for less than their liquidation values. Stockholders must bear the blame, for they do not intervene on issues where management cannot be expected to act in the best interests of the owners. Graham and Dodd note that investors exercise more care and judgment in purchasing a stock than they do once they actually own it, which is unfortunate.

The stockholder does what the board of directors tells him to do. Often, the board of directors are simply associates of management. As such, the stockholders interests do not get served.

The authors believe this arrangement is not challenged by shareholders because management knows more about the business than anybody. Though this is true, it is dangerous for shareholders to obey management for this reason, for it does not follow that management will adopt the most beneficial course for shareholders. There are certain issues where management and shareholder interests are at odds with each other. If shareholders do not weigh in, the outcomes of these decisions will be decidedly in management's favour.

Issues where management and shareholder interests are at odds include management compensation, expansion of business (could have low returns, yet increase prestige for management) and dividend policy (shareholders get paid, but management loses safety net funds). In the case of the liquidation of a company, management would lose their jobs! Clearly, shareholders must realize this conflict of interests between management and shareholders when a company is trading below its liquidation value, as management will usually do its best to keep the company as a going-concern.

The authors conclude the section on balance sheet analysis by discussing various negative factors to be aware of before making an investment decision. For one thing, approaching debt maturities can be disasters. A company may have an excellent earnings record, but if earnings or the economy were to turn negative near the time a refinancing is required, a devastating default situation could occur.

Finally, even if a company is reporting losses on its net income, the sources of these losses can be viewed item-by-item by comparing balance sheets over time. A company's financial position may actually improve in the eyes of a security analyst despite losses! For example, if the analyst had weighed the value of liquidation inventory at 80%, but the company had converted 90% of its inventory to cash (through sales), it would present a loss on the income statement, but would have converted a large portion of inventory to cash, which is sure to excite the security analyst!